Helping Clients Maximize Inherited IRAs

Not to be ominous, but we don’t live forever and the older a person gets, the higher the probability of death is. That’s one obvious reason why estate planning with clients is essential and why that needs to be among the services offered by advisory firms.

Estate planning is also essential because the older a client is, it’s reasonable to surmise that they have more assets that need to be accounted for and worked into the estate plan. Those included individual retirement accounts (IRAs).

Advisors need to ask clients about IRAs and how they’d like to bestow those accounts to heirs. Fidelity Investments’ Q2 2023 retirement analysis indicated the average IRA balance was $113,800 – a decent chunk of change. It’s likely that the figure has increased because the S&P 500 is higher by 22.2% over the past year.

Where advisors figure into the equation is by way of new rules set forth by the SECURE Act pertaining to inherited IRAs bequeathed by folks that passed away in 2020 and later. Many of the new guidelines pertain to how IRAs are passed down, but the emphasis here will be on strategies for clients that inherited IRAs.

Strategies for Those Inheriting IRAs

It’s not on clients to know about all the “plumbing” that comes with inheriting an IRA. That’s why they have advisors and it’s the advisor’s job to articulate the options the client has upon inheriting an IRA. Those include disclaiming the inherited capital.

“The assets would then pass on to an alternate beneficiary, such as another family member, or to the estate if no other beneficiaries are named,” notes Hayden Adams of Charles Schwab. “Disclaiming the IRA can be a smart option if you're financially secure and want to avoid potential tax consequences of the additional income. Be aware that you'll need to disclaim the account within nine months of the original owner's death and before taking possession of any assets.”

Another option for the client inheriting an IRA is to take a lump-sum distribution, but that choice has some drawbacks, particularly if the IRA in question is traditional, not a Roth.

“There are a couple of downsides to distributing all the assets, however,” observes Adams. “First, if it's a tax deferred account (like a traditional IRA) the IRS will tax the funds as ordinary income, which could move you into a higher tax bracket. Also consider that by not keeping those assets in a tax-advantaged account, you could lose out on the potential benefit of any additional tax-deferred appreciation.”

Consider Stretching, Other Ideas

It’s possible that the inheritor of the IRA can simply move the assets into their own existing IRA, but that option is only available to surviving spouses. So advisors should not present this option to children of the deceased. For those that don’t need the money in the inherited IRA over the near-term, there’s the stretch provision.

That’s a practical idea for many clients, but they must be designated beneficiaries to take advantage of stretch benefits.

“Assuming you don't need all the money at once, you could transfer the funds into an inherited IRA held in your name, sometimes referred to as a ‘stretch’ IRA,” according to Adams. “This option enables you to take annual RMDs over many years, allowing the bulk of the money more time to potentially grow tax-deferred.”

Other ideas for advisors to discuss with clients include distributing the assets in the IRA over 10 years or doling out that money through the will or estate, but the latter option is usually best-suited for clients that aren’t designated beneficiaries of the IRA.

Related: The Need for Advisors Is Getting Stronger